Telstra basks in good news as investors look for safety

TELSTRA shares are at a 3½-year high as investors rush to familiar and reliable companies and shun shares exposed to a potential slowdown in global growth, particularly in China.

The big telco has enjoyed a three-month rally since an investor update in April. The shares hit $3.90 this week and now exceed the average of analysts' target prices by nearly 30¢.

There are several reasons for the strong price. Telstra is an attractive haven for institutional investors in the run-up to what could be a rocky reporting season. Fund managers can park money in Telstra until all the good and bad news is revealed throughout August and September.

And Telstra is still yielding a 7 per cent return, which is attractive for risk-averse retail shareholders and above term-deposit rates. Chief executive David Thodey confirmed in April that the fully franked 28¢ dividend would be paid until mid-2014.

Bell Potters managing director Charlie Aitkin released a note last week lauding the new management, regulatory certainty and the potential for the company to share with shareholders the money from its deal with NBN Co.

''I see Telstra annual dividends rising from 28¢ to 32¢ over the next few years - that excludes any special dividends,'' he wrote on July 10. ''I also believe the stock will trade to a 6.5 per cent yield from its current 7.3 per cent yield as the market effectively lowers the risk rating on the stock. On the 28¢ dividend, that equates to a $4.25 price target. On a 32¢ dividend that equates to a $4.85 price target.''

But Mr Aitkin's view is not an official target price, and there remains a discrepancy between the current trading price and the average analyst target price.

In particular, there is a figure known as the ''weighted average cost of capital'' (WACC), which affects analysts' calculations.

The WACC is determined through complex calculations and assumptions about the different types of capital (debt and equity) used by Telstra to fund its business.

Costs are measured against approximate risk factors. Higher funding costs and higher risks create a higher WACC. A lower WACC increases returns because the company can borrow cheaply.

Telstra uses an internal weighted average cost of capital of 10 per cent, according to a memorandum it released last year.

But 10 per cent was selected at June 2010 when borrowing costs and the official cash rate were higher. Telstra has also benefited from low commercial borrowing rates - former chief financial officer John Stanhope said in February that Telstra borrowed $800 million from Bank of China at 80 basis points above the bank-bill swap rates, less than the government pays to borrow money.

All this leads to suspicion that Telstra's earning power is higher than its published WACC. Understandably, the company will not reveal its true cost of capital.

According to Bloomberg's ''rough approximation'', Telstra gets 74 per cent of its funding from equity and 26 per cent from debt, with a WACC of 6.5 per cent.

Analysts have started adjusting their valuations ever so slightly. And if they decrease the WACC, this could lead to increases in target prices. Royal Bank of Scotland analysts recently changed their valuation to include a long-term decline in the cost of government borrowing.

''Our valuation increases to $3.80 (from $3.60) as we reduce the risk-free rate in our discount-cash-flow calculation to reflect the decline in the 10-year bond rate (we now use a WACC of 9.0 per cent versus 9.5 per cent previously),'' they wrote in June.

Citi equities research has a $3.35 target price based on a combination of expected earnings over the next 10 years and cash flows from the deal with NBN Co.

Merrill Lynch analyst Sameer Chopra also has a $3.35 target, while Commonwealth Bank's market research team recently increased its target price to $3.54 from $3.51 due to a slight increase in earnings per share in 2013-14.